Learn from history

What's a good investment in Warren Buffett's eyes? We'll show you one in this article, and though he did the mistake of probably overestimating its future earnings, it still went alright. We'll let you know why if you read along.

There is a lot to learn by reading his letters, as we have promoted in our Books section on the website. We can also recommend the book by Adam Mead, The Complete Financial History of Berkshire Hathaway (affiliate link), a book we are currently reading.

By reading about the companies Warren Buffett has bought earlier in the past, you can get clues and ideas about what he thought was smart to buy back then. You can look at the type of business, its competitive strength perhaps, and you can even study what the numbers of the company was, and at what price he bought it for.

We will focus on the numbers and pricing in this article, for two companies as examples. At what price did he think he made a good investment?

The XTRA Corporation

Berkshire bought the XTRA corporation in September 2001 for a total purchase price of about $578 million.

The business of XTRA was simple. They owned trailers used on trucks, and they leased them out to trucking companies and other companies that move freight.

The numbers

When Buffett was reading the numbers for the business he could see that revenues were quite stable and slightly growing, from $461 million in 1998, to $464 million in 1999, to $477 million in year 2000. The money they were earning before interest and tax, the EBIT, was close to $160 million the last three years give or take a few million, giving the business an EBIT-margin of 33-35%.

The business also had high return on capital employed, around 13-14% pre tax.

Pricing and valuation

As we wrote above, the purchase price was about $578 million for 100% of the equity of the company.

Buffett might have thought he paid a fair price for the company. Price/book for the purchase price was about 1.6. Equity in the business was around $360 million if we calculate it correctly. The business also had debt, that Berkshire took over, totaling a meaningful amount of $788 million. That gives a total price of $1,366 million for equity and debt.

We don't have the exact price/earnings for the deal, but the ratio of price to pre-tax earnings was about 3.6 ($578/$162= 3.6).

The US 30-year treasury rate was about 5.6% at the time of purchase in September 2001.

If we take into consideration that Berkshire took over the debt of XTRA, the total going-in pre-tax return was 12.0% for the investment.

How the future panned out for XTRA

The first decade after the purchase the earnings of the business didn't go quite that well. In 2003 the earnings had dropped to $34 million, but in 2004 it rebounded to $92 million.

One strategy that may have helped them get more profitable again was to give up the container and intermodal business it previously entered, and rather focus on its core trailer-leasing business.

The business barely made a profit during the financial crisis in 2009. And in 2010 it earned $35 million again, with better utilization.

The development of the company's earnings thereafter went quite well. In 2012 they earned $106 million pre-tax, and they increased it to $147 million in 2014.

Compared to the total investment of $1,344 million in 2001, they started out with a 12,0% going-in pre-tax return. And after 13 years, in 2014, they earned 10.9% on the investment.

It was so far not one of Warren Buffett's best investments, but one could still call it satisfactory, and he didn't lose money, which is Rule #1!

Why it went well after all

Since Buffett paid a fair price for the company, meaning he didn't overpay, he came out of the investment quite well. Even though earnings were lagging after many years, the investment turned out well over time. The reason was that he applied a margin of safety. A margin of safety protects you from making bad investments in case you are wrong about the future earning power of the business. 

If you want to learn a bit about what we have figured out that works when it comes to investing the right way, feel free to continue reading our article from last month, Some Insights into our Investment Approach. Perhaps you will find something that was missing in the XTRA deal?